I’ve been pounding the table pretty hard on investment bubbles lately. Probably because in the last decade, I’ve experienced more popped bubbles than I care to remember.

Or perhaps it’s that I’m constantly amazed by the herding behavior of humans. After all, we’re not that different from the rest of the animals on Earth, so it’s not difficult to believe that if our neighbor, our dentist, the stock analyst on CNBC, and even our local 6 o’clock news anchor says that everyone is doing it, that we’re afraid we’re going to be the Poindexter standing in the corner all by our lonesome.

Hey, if it worked so successfully for Obama’s behavioral psychologist dream team, why shouldn’t the “people want to do what they think others will do” vibe work on investors after the quick buck? It’s not mind control per se, it’s just a few highly intelligent prognosticators coming up with clever ways to get you to do something… before you know you want to do it.

Psychology of an Investment Bubble

Since I’ve gotten a fair amount of feedback — both for and against the presence of a gold bubble — I thought it would be fun to graphically examine the psychology of an investment bubble as it’s forming and after it has popped.

Moreover, what the emotions are like as different types of investors (value investors, fast money momentum traders, and Everyday Joe retail investors) were thinking as the newest investing fad forms a bubble, then quickly bursts.

Stealth Phase

More than likely, these are the value investors and buy on the dips investors. They’re probably the most infuriatingly patient and purposely coy investors on the planet because they will wait for months or years to get the right P/E ratio or the bad earnings report, and swoop in to buy as much as they can while it’s cheap as dirt. They really don’t care what the rest of the world is investing in at the time, they just want to get maximum value for their money invested. These are the Warren Buffett’s and Wilber Ross’ of the investing world.

Awareness Phase

These are the big money institutional investors who pour over stock charts and fundamental analysis screening programs 18 hours a day, and have a dedicated research team to be on the lookout for new opportunities. It’s their job to do the research, read everything down to the 10Ks, and beat the bushes to find the growth of a sector or commodity before anyone else does.

Mania Phase

This is when the investment goes 100% mainstream. It will get mentioned in every publication from the Wall Street Journal to The Today Show. This is when the bubble often traps the retail investor by showing past performance and gives the illusion of future appreciation (there is a reason why investments say past performance does not guarantee future returns). Then it begins to act a bit of a euphoric or narcotic like effect where it blinds the part of the brain that says “Wake Up You Smuck!” and all they think about 20% gains in a month and two stock splits a year. In other words, it’s purely unobtainable mania brought about by something proverbially spiking the punchbowl.

Blow Off Phase (aka – Bailout Phase)

Usually accompanied by a “it will come back” mentality and a general lack of comprehension that you’ve just been screwed but haven’t gotten the morning after thank you call. The big institutional investors and fast money traders will have predetermined stop loss orders in place, and when those are tripped in mass quantity, the bottom completely falls out and panic selling begins. The best traders will also begin to pile on the shorts accelerating the sell off. IN the end, the value will be pushed below the historical trendline since we’re just as likely to overreact on the downside just as much as we’ll overreact on the upside.

Examples from Bubbles Past

Oil Bubble

Who can forget that pesky thing called an oil bubble? You know you loved paying $4 to $5 for a gallon of gas… especially when you drove a SUV that cost around $100 to fill up every five days.

Notice the massive run up to $147 and the horrendous sell off back down to $35 per barrel. It took 5 years to create this bubble, but when it popped, man … look out below! [echos]

See any similarities between this chart, and the psychology of bubbles graphic above?

Real Estate Bubble

It almost makes you say WTF! Take a look at the massive deviation from the historical trendline. It begs the question if the real estate bubble was artificially created (thank you Rubin, Greenspan and Wall Street) or if we had legalized marijuana back in 2000 and got happy with the mortgage paperwork.

Nasdaq Tech Bubble (aka Dot Com Bubble)

Who can forget the good ol’ tech bubble? That much loved period when America could do no wrong and any crappy company could create a website and double in value two months later. Sad thing was that these companies had great fundamentals (according to most everyone) and the huge run up in prices was sufficiently validated.

And you were vilified if you said anything to the contrary.

It was such a fiasco that finally in late 2009 — a decade later — that a small number of those high flying tech stocks are finally breaking even on their old 1999-2000 highs.

The Gold Bubble?

Now that gold has breached $1000 and apparently destined to above this price point forever, it almost makes you wonder if we’re just setting ourselves up for the same thing.

But take a look at the chart, the newspapers, and the people around you. Can you see the similarities between gold and the rest of these bubbles? Can you connect the dots?

Sure, gold has some good fundamental reasons for being above $1000 per ounce, but if you’re late to the party, do you really want to invest at these levels knowing that going long gold (and shorting the U.S. Dollar) are the most crowded trades on Wall Street in late 2009?

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Disclosure: I’m neither long nor short gold. I’m just a guy on the sidelines making observations about the gold rush.

since i have started investing early, i want to be “the warren buffetts and wilber ross’ of this world”. These annoyingly patient investors seem to laugh last all the time and then when the wait has paid off big, we call the investing geniuses while it was just good research and patient investing (this is really resounded in all the books that these super investors have endorsed and since it seems to work for them, i guess it is the way for me)

Nov 15, 200911:44 am

#5 Matt SF :

@ Arohan,

That’s certainly a possibility, but I tend to get suspicious once the charts go from linear to exponential. I think it’s just a case of too far, too fast.

Nov 15, 200911:48 am

#6 Matt SF :

@ Kenyantykoon,

I’ve been trying to do the same thing lately. That’s why I mentioned the “buy on the dips” investing/trading mentality of guys like Buffett and Ross. Not sure if I’ll ever get there, but it’s just a matter of seeing the diamonds in the rough or being a savvy vulture investor and swooping in at the appropriate time (when everyone says it’s over, might be the best time to buy).

Ok, Matt… I bet the world doesn’t come to an end by end-2012 either. :)

Mar 13, 201111:25 pm

#9 Abitibidoug :

Think of an engine equipped with a governor. If there is a load increase and speed drops, the governor senses the speed drop, pulls the throttle open, which increases power, and the speed goes back to the desired level. Similarly, if there is load loss and the speed increases, the governor closes the throttle, which decreases power and the speed returns to the desired value.

Why don’t asset values behave that way? For example, when gold is at a high value like now or 1980, why isn’t there a massive sell off, which holds the price down? Similarly, in 1999 when gold was cheap, why wasn’t there a frenzy of panic buying to get in at the lower price? Some food for thought.

You’re implying that humans (which set the asset values) behave in a rational, mechanically “governed”, perfect common sense method. If behavioral economics teaches us one thing, it is that we are from that capability.

But, in regards to the question of in 1999 when gold was cheap, why wasn’t there a frenzy of panic buying to get in at the lower price? my answer is because people go where the action is, and where mainstream media tells them to go.

In 1999, you were a fool if you didn’t own JDS Uniphase or CMGI. In 2011, it’s gold, silver, fertilizer.

Trends change, and when this happens on Wall Street, it usually happens violently with the Greater Fools bearing the heaviest burden.

Apr 22, 201111:44 am

#11 garyf :

Matt,
OK. I agree that the man-beast is a lemming at heart. But we used to be on a gold standard for good reason. Now we are off and as long as the USD is falling I don’t see how Au/Ag can’t continue upward. Same goes for oil as long as the USD is the reserve currency. But perhaps the real question is when to sell. Your psych maps suggest that you should wait for the first dip after the exponential peak then buy like crazy until you reach the original maximum then selloff. Could it be that simple? That is, wait for the market to go critical, buy on the dead cat bounce, and sell near the original peak?

I don’t think there is a definitive point where we “should” sell, because no one but a lucky few will time it precisely right.

But the smart money, as quaint as it sounds, buys cheap and goes long only to liquidate smaller portions of their position into strength.

It’s not all that sexy because you can’t say you sold at the absolute top, but very few people go broke by taking profits.

This is one of those scenarios where the fear of not making enough money or the trader across from you making more money than you — greed — plays tricks on the mind overruling the rational side of your brain.

If you can’t overrule it, best to at least acknowledge it so that when the decline happens, you know to get out before the panic selling begins.

Jun 10, 20115:46 pm

#13 Frank Swistow :

Well Gold has just been added to the major indices on the Yahoo finance home page http://finance.yahoo.com (Nasdaq, Dow, S&P 10 yr bond Oil and now Gold). If that doesn’t scream that Gold is at or near its top then I don’t know what does.